The period from 2017 to early 2019 saw what can only be called a “hype train” or mania in the world of cryptocurrencies:
Narrowing and reassertion of Bitcoin
In our 2018 report, Cryptocurrencies: Fool’s Gold or the Future?, we highlighted survivorship as one of the main risks with cryptocurrencies. Most had the potential to disappear through obsolescence or because the field was overcrowded and they simply weren’t needed. Since then, the blizzard has cleared, and the field of coins taken seriously has narrowed. Furthermore, “Bitcoin dominance,” or the percentage of cryptocurrency market capitalization in Bitcoin, has been reasserted. Bitcoin dominance was well above 80% going into 2017 but fell to 33% by January 2018 at the height of altcoin and ICO exuberance. However, by June 1 of this year, Bitcoin dominance had climbed back to 65% as the cryptocurrency field narrowed.
The above phenomena of narrowing and Bitcoin dominance are related in that Bitcoin has essentially acted as the reserve currency for altcoin purchases and sales. As altcoins have diminished in importance, balances have flowed back to Bitcoin. This makes it hard to build a diversified cryptocurrency portfolio, as investors remain highly exposed to the idiosyncratic risks of one asset. The risk is even greater for those with a coin market cap benchmark starting point.
In Q1 2020, cryptocurrencies suffered the effects of broader economic problems sparked by the COVID-19 pandemic. Investors (institutional and individual) in need of capital sold almost any liquid asset, and cryptocurrencies are relatively liquid. Cryptocurrencies endured a long squeeze, exacerbated by extreme leverage limits in cryptocurrency markets (up to 100 times on some exchanges). As investors sold Bitcoin to cover their margin calls, the price further decreased, leading to a cascade of redemptions.
Bitcoin began to recover in March, well before broader equity markets, and it has so far fared better than equities in 2020 (see Figure 2). However, investors may have to get used to cryptocurrencies falling in ”risk-off” market crises. Risk-off environments occur when market participant appetites for risk dry up, usually in response to bad economic news although sometimes due to purely technical market events. At this point leveraged long-term positions are unwound, exacerbating initial market falls. This means that low correlations with traditional asset classes that could have justified investing in cryptocurrencies are evaporating quickly as cryptocurrencies respond to wider market occurrences.
Figure 2. Bitcoin and equities in H1 2020, USD returns
Source: Coinmarketcap and Thomson Reuters Datastream. The MSCI ACWI Index is designed to represent performance of large- and mid-cap stocks across developed and emerging markets. It covers approximately 85% of the free float-adjusted market capitalization in each market covered. Here the MSCI ACWI Index is used to represent the universe of listed and liquid equity stocks.
Recent correlation statistics between cryptocurrencies and traditional risk markets are inconclusive. However, a more qualitative perspective suggests that cryptocurrencies have a low correlation during low volatility but respond to both surges and crashes in equity markets. This is relatively intuitive.
Cryptocurrencies have evolved from a penny-ante game played by computer enthusiasts to a much more mainstream store of value. They are a big deal. As equity markets boom, some investors will trim from their holdings and allocate to Bitcoin and other cryptocurrencies. While early-uptake “HODLers” of cryptocurrency may approach crashes with relative sangfroid, a new breed of investor is likely to panic sell.
Below are some important tailwinds and headwinds for cryptocurrencies.
Cryptocurrencies have a track record, albeit a relatively short one, of resilience after large crashes, and it’s difficult to imagine a scenario which would cause a sudden end to their use. The entrenched user base lives and breathes cryptocurrency, and users are steady in their convictions. However, despite the reassertion of Bitcoin dominance, it is still far from clear whether we presently have the cryptocurrencies of the future. State or corporate actors could take over at some point. We have seen now that cryptocurrencies are not immune to wider market fallout, as correlations have begun to emerge, and the volatility and future uncertainty remain extreme. This raises questions about how much diversification benefit they actually add to a portfolio on an asset class level. Within the asset class, cryptocurrencies are primarily dominated by Bitcoin and thus highly exposed to idiosyncratic risk.
At this time, we still see risks and general uncertainty in this space outweighing potential benefits and would thus caution investors against investing in Bitcoin and altcoins. Cryptocurrencies do however cater to the contrarian and may be of interest to individual investors, but they should be accompanied by risk warnings of sufficient gravity (cryptocurrencies are an order of magnitude riskier than traditional investments). Cryptocurrencies are largely unregulated investments and should be presented as such. Investors should obtain legal advice regarding investment suitability and should avoid their use in countries where cryptocurrencies are banned.
The same risks and issues apply to institutional investors. But investors who are alert to these risks and have a sufficiently futurist perspective, access to digital expertise and an interest in positively convex investments might make a small allocation in their opportunistic portfolios.
 Pozzi D. “ICO Market 2018 vs 2017: Trends, Capitalization, Localization, Industries, Success Rate,” Cointelegraph, January 5, 2019, https://cointelegraph.com/news/ico-market-2018-vs-2017-trends-capitalization-localization-industries-success-rate.
 We refer the reader to the previous report for primer information on cryptocurrencies.
 Initial coin offering.
 The jocular term “HODLer” denotes a determined, come-what-may, long-term owner of a cryptocurrency
 Deutsche Bank forecasts an estimated 200 million wallet users by 2030. Deutsche Bank. “Imagine 2030,” Konzept, December 2019.
 Cipher Trace Cryptocurrency Intelligence.
 Often, investors focus on the mean/average expected result — for example, they might invest in an equity portfolio and expect to harvest the equity risk premium. Some investors look instead at the range of possible outcomes for an investment. They focus on investments that have asymmetric return profiles, where there is a small probability of a very strong upside (although a high probability of losing money, or not gaining much). Imagine a “popcorn popper” portfolio where, occasionally, a kernel of corn pops and shoots up. Examples of such investments are single-company opportunities in distressed debt or venture capital, and cryptocurrencies, and these are positively convex investments. A lottery ticket is an example of an investment with extreme positive convexity, whereas an investment grade credit portfolio typically has negative convexity (limited upside, unlimited downside).
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